PEG Ratio Useful But Not Perfect

3/25/2013


Imagine a single number that takes into account a stock's value as well as its long-term growth prospects. The price/earnings-to-growth (PEG) ratio does just that, dividing the P/E ratio based on estimated current-year earnings by projected annual profit growth over the next five years.

For example, Qualcomm ($65; QCOM) trades at 14 times estimated earnings for the fiscal year ending September 2013, a 25% discount to the average communications-equipment stock in the S&P 1500 Index. Factor in Qualcomm's long-term annual growth estimate of 15%, and the stock looks even more attractive — its PEG ratio of less than 1.0 is 46% below the median for its peer group.

At first, the PEG ratio might sound like the holy grail of investing.

But in practice, it is more guide than grail, and it has drawbacks. The reliability of long-term forecasts is suspect, as estimates for even one or two quarters are subject to major revisions as reporting seasons draw near.

Since the start of our data in 2004, the top quintile (one-fifth) of the S&P 1500 Index as measured by PEG ratio has averaged 12-month outperformance of 1.8%, among the top one-third of Quadrix® Value factors in effectiveness.

Like most Value metrics, the PEG ratio has performed poorly recently; in the last 12 rolling periods, stocks with high PEG scores averaged 4.7% underperformance. However, Value has been effective over the long haul, and PEG and other ratios should regain their predictive power.

SIX PEG PLAYS
The recommended stocks below have PEG ratios more than 20% below their industry average. Also, all six trade at least 14% below their peer group based on expected current-year price/earnings ratios.
---------- PEG Ratio ----------
Estimated 5-Year
---- EPS Growth ----
P/E On Est. EPS
For Current
---- Fiscal Year ----
Company (Price; Ticker)
Ratio
Quadrix
Rank
Discount
To Indust.
Average
Growth
Premium
to Indust.
Average
Ratio
Discount
To Indust.
Average
Apple ($454; AAPL)
0.7
92
34
15.0
20
10.3
25
Bed Bath & Beyond
($62; BBBY)
0.9
79
33
14.6
2
13.6
11
DirecTV ($55; DTV)
0.7
89
30
15.1
4
11.2
27
Express Scripts
($59; ESRX)
0.9
82
42
16.3
14
13.9
25
Foot Locker ($32; FL)
0.7
79
46
15.5
12
11.4
40
Qualcomm
($65; QCOM)
1.0
73
46
15.0
6
14.4
25
S&P 1500 Median
1.4
45
11.9
16.5
Note: Quadrix ranks are percentile ranks, with 100 the best.

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